Lessons from the fading commodity supercycle

Prices of raw materials-crude oil included-have plummeted, signaling the end of a 15-year commodity boom. The implications for countries and businesses are far reaching.

The past 12 months have seen a precipitous drop in many primary commodity prices. Crude oil prices have collapsed, with the price of Brent crude falling from well over $100 per barrel last year to less than $60 earlier this year. Likewise, iron ore prices declined from around $95/metric ton to below $50, and rubber prices tumbled from nearly $2.00/pound to less than $1.60. Collectively, commodity prices, as measured by the IHS Material Price Index (MPI), have fallen more than 36% since July 2014.

Last year's commodity crash was not totally unexpected, but the speed of the decline for many commodities took most traders by surprise. Indeed, the IHS MPI, a weighted average of weekly input spot prices for the manufacturing sector, went into a near-free fall during the second half of 2014. The index had in fact been on a downward path for the prior four years, after having hit its cyclical peak in late April 2011. Since then, despite periodic short-term rebounds, it has generally been trending down and currently stands more than 53% below its 2011 peak.

As the price decline has unfolded, an increasing number of market analysts have been heralding the end of the powerful commodity boom that had persisted for most of the past 15 years. Some more bearish analysts go even further, suggesting that the commodity crash is a leading indicator of a powerful global deflationary wave that is constraining the world economy. Moreover, there is a growing consensus among commodity bears that the boom-bust commodity cycle was a natural consequence of the past several decades of rapid liquidity growth and excessive debt accumulation.

The evidence supporting the commodity bears is now very strong. Among the 53 commodities for which the International Monetary Fund (IMF) publishes monthly price data, the vast majority show prices that are currently 40-60% below their 1980-2015 peaks, and nearly all the others have fallen 15-37% from their high points.

To be sure, there are still some commodity bulls who contend that the ongoing downturn is only a pause. Indeed, they view current prices as an opportunity for accumulating assets at bargain levels. These stalwarts expect prices to rebound soon and to reach new all-time highs over the coming years. The bullish case has become increasingly difficult to maintain as commodity prices have continued to sink.

What causes commodity price volatility?

The central reason for the high volatility of commodities is that both their demand and supply can experience large changes in relatively short periods.

Supply can be very "lumpy," especially in the case of mega-mining projects, particularly in some of the gigantic mines today in Australia, Canada, Brazil, Russia, Mongolia, and West Africa. Similarly, discoveries of new oil reserves frequently come in the form of huge new plays. As a result, increases in production capacity can come in large chunks, making it difficult at times to match demand with supply. The problem of managing production growth is often accentuated by the long lead times of energy and mining projects, which stem from their increasingly challenging regulatory environment. Consequently, it is not that unusual for oil and mineral supplies to go through periods of oversupply, with prices crashing, followed by periods of shortage, when prices start to rise and sometimes boom for an extended period.

Severe weather conditions and other natural disasters can also upset the supply side. Some of Australia's iron ore and coal mines, for example, have occasionally had to halt their operations for extended periods as a result of flooding caused by severe tropical storms. Geological disasters can also disrupt supplies. Earthquakes are an obvious case, but even giant sinkholes can be extremely disruptive for mines located in regions susceptible to such an event-such as some of Russia's giant potash producers in Siberia.

Political risk can further disrupt commodity supply and spark price volatility. This has historically been a major problem in the case of mineral supplies from developing countries. Because of their weak institutions, developing countries are vulnerable to political instability and violent conflicts, which can damage production facilities and transport infrastructures.

The concentrated supply structure of some commodities can lead to market instability. The best example of such concentration is the high share of traded petroleum originating in a handful of countries in the Persian Gulf. Over the last several decade, almost any political or policy change in these countries has made commodity markets nervous and often had major impact on oil prices.

Demand swings can also destabilize prices. Decisions to increase or decrease the desired levels of inventory during the course of a business cycle can greatly amplify changes in apparent consumption and cause short-term price volatility. Since some commodities are traded in open exchanges, this can add to their volatility as well. To be sure, investors generally benefit from the resulting increased transparency and liquidity. Such benefits come at a cost, however, since financially traded commodities attract speculators and are vulnerable to swings in investor sentiment that sometimes are divorced from the markets' physical fundamentals.

It is important to note that accentuated commodity boom supercycles that deviate greatly from their physical fundamentals are not possible without a permissive monetary environment. Indeed, supercycles have their origins in reflationary monetary conditions and are fueled by negative real interest rates or excess liquidity growth.

Commodity supply-and-demand dynamics make it difficult for markets to achieve a stable equilibrium. Even when a commodity market does reach balance, it is unlikely to last long. Commodity markets require constant-and on occasion, major-adjustments that can sometimes only occur through huge price movements.

To be sure, there are still some commodity bulls who contend that the ongoing downturn is only a pause. Indeed, they view current prices as an opportunity for accumulating assets at bargain levels. These stalwarts expect prices to rebound soon and to reach new all-time highs over the coming years. The bullish case has become increasingly difficult to maintain as commodity prices have continued to sink.

Parallels among supercycles

The history of past supercycles shows that they have similar dynamics, even though each has unique characteristics (see sidebar 1 at the end of this story). Factors that influence supercycles include economic and political shocks, government policies, diffusion of new technologies, and investor psychology. These sometimes work in concert to accentuate a cycle by increasing its amplitude and/or stretching out its duration. Ultimately, however, all economic booms that lead to commodity supercycles are powered by rapid liquidity growth and/or negative real interest rates.

The dynamics of the latest supercycle-which IHS believes came to an end in 2014-are essentially the same as the four that occurred in the twentieth century. High liquidity growth and/or negative real interest rates were its key causal factors during most of the past 20 years. The liquidity boom that characterized the late 1990s was fueled mainly by European banks and US venture capitalists, and subsequently by the response of major central banks to the economic downturns that followed the high-tech bust of 2001 and the Great Recession of 2008.

The easy money on tap during those years helped inflate various asset bubbles, and drove energy and raw material prices to unsustainable levels. Certainly, the severe credit squeeze that was triggered by the Great Recession caused a violent crash in commodity prices. But the monetary authorities' aggressive reflationary measures-including negative real interest rates and quantitative easing-halted the adjustment process and stimulated another boom in many commodities that ended only a few years later; roughly in 2011.

The fact that reflationary monetary measures were left in place for such a long time aggravated the problem, since they fueled a powerful debt-financed consumption and investment boom that eventually became unsustainable. The reflationary measures did succeed in igniting global recoveries in 2003 and 2009, but they also created new asset bubbles. In particular, they set the stage for the increasing "financialization" of commodity markets. Indeed, the growing participation of financial market investors in commodity trade likely contributed to the excessive rise in prices during the boom, worsening the subsequent bust.

Where to next for commodity prices?

IHS contends that most prices have fallen sufficiently for the market to at least find short-term price stability near their current levels. Indeed, when measured in most major currencies, commodity prices have probably already hit bottom.

There are two reasons why further declines will likely be limited. First, for many commodities, prices are approaching production costs, placing at least a temporary floor under prices. Second, while the global economy's expansion has been lackluster over the past several years, we do see a slow improvement in growth ahead, which should provide some degree of demand support.

What do these mean for commodity prices? IHS expects any recovery in prices to be fairly muted over the coming quarters, particularly since IHS believes that China's economy is set to edge down further in 2016 (see sidebar 2 at the end of this story). As a result, excess production capacity in many sectors should constrain price increases in most commodity markets for at least another year. For some commodities, such as iron ore and aluminum, abundant capacity will likely ensure downward pressure on prices for some years.

The history of past supercycles suggests that a disorderly price correction, such as the one we have witnessed during the past 12 months, is usually followed by a long period of relatively weak pricing power and underinvestment in commodity markets. After a powerful boom usually comes a long, painful bust that discourages investment, but eventually sets up the markets for the next commodity boom and sometimes a supercycle. So the odds are that commodity prices will remain relatively flat, rather than recover strongly, for at least several years. Indeed, IHS believes commodity prices will not regain their early 2014 levels for the rest of this decade. After an initial short-term cyclical rebound, real prices might slowly drift higher, but they are still likely to remain far below their 2014 levels even by 2025.

Winners and losers

The impact of the decline in commodity prices has been highly uneven across countries. Broadly speaking, all net importers of energy, food, and other raw materials have benefited at least modestly from the improvements in their terms of trade. But for many net exporters, the economic situation has deteriorated severely. At the global level, however, the net effect on world growth appears to have been minimal, with the positive impact on net commodity importers being offset by the negative impact on net exporters.

At the micro level, the lower prices have certainly had a positive impact on the finances of most households and businesses around the globe. From a macro level, however, there have been many losers as well as winners. The economies that have benefited most from the lower prices are those that are primarily manufacturing or service oriented. Since these economies do not receive much income from primary commodity production and exports, they are unlikely to see a major negative shock from the crash in commodity prices. The benefits to these economies from lower prices are likely to be rather modest, however, since the aggregate value of their commodity imports is relatively small compared with the overall size of their economies.

Among developed countries, those that have seen a significant boost to their economic growth in recent quarters are mostly in Western Europe, but this has been mainly due to improving fiscal and monetary conditions rather than lower commodity prices. In fact, IHS estimates that lower commodity prices have added less than 0.3% to the regions' GDP growth since June 2014.

When it comes to the impact of lower prices on emerging markets, the countries that have seen notable acceleration in their economic growth in the wake of last year's commodity price crash are primarily located either in Central Europe or the Caribbean. Here as well, the contribution of lower commodity prices to economic growth has been rather modest-roughly 0.2% to 0.3%.

As noted above, clearly the end of the supercycle has hurt the economies of all net commodity exporters, which are overwhelmingly emerging markets or developing economies. There are only three major net commodity exporters that are advanced economies-Australia, Canada, and Norway. These three countries had benefited immensely from the booming commodity prices during the last decade and a half, but they are now facing a very challenging period of austerity that will likely last several years. These developed economies are likely to come through the period of adversity in relatively good shape, however, since they generally have effective decision-making organs, strong financial institutions, stable political systems, and wealthy populations.

The biggest losers at the end of the supercycle are the developing countries that earn most of their foreign exchange inflows from exports of energy and/or minerals-in other words, most countries in the Middle East, Africa, and South America, as well as some in Asia. The economic situation of these countries has already deteriorated rapidly since 2014, and their prospects are expected to remain negative as long as commodity prices remain depressed.

The adverse impact of the lower prices on net commodity-exporting economies will vary, depending on the degree of reliance on commodity exports, the extent of its diversification, and the strength of its macroeconomic fundamentals. The ones that are coping best with the commodity crash are the ones with dynamic manufacturing sectors, such as Indonesia, Malaysia, the Philippines, Vietnam, and Mexico, since they are benefiting from lower input prices for their manufacturing sectors. Affluent petroleum exporters, like Saudi Arabia, Kuwait, and Qatar, should be able to manage the situation with only a limited amount of austerity, since they can tap their ample foreign exchange reserves and vast accumulated overseas assets.

Farid Abolfathi is senior director, Economic Risk, IHS Economics & Country Risk; John Antonis senior principal economist, and John Mothersole is research director, Pricing & Purchasing, both with IHS Operational Excellence and Risk Management.

Sidebar 1: Commodity supercycles since 1900

When aggregated into a single broadly representative index, commodity price movements show far less short-term volatility, and the supercycles stand out much more clearly.

Over the past 112 years, two small supercycles were recorded during the first two decades of the 20^th century followed by three giants: one in the 1920s, another over the 1970s, and the third during the last decade. The first of the two smaller supercycles, which spanned 1892-1905, was associated with Germany's rapid rise as an industrial and geopolitical power. The second, which covered the years from 1916 to 1919, was related to supply disruptions during World War I and the rise of the United States as an emerging economic power. A key reason for the small amplitude of these two early supercycles was that the central banks of those eras could not accommodate the boom periods with aggressive reflationary policies since currencies were tied to gold prices, which did not allow any flexibility in monetary policy.

The first truly giant supercycle in the 20^th century was from 1926 to 1929, the four years immediately preceding the Great Depression. During that period, permissive lending by banks and an insatiable appetite for speculative investment by businesses and households led to excessive leveraging of the private sector, especially in the United States. After the boom turned to bust in late 1929, commodity prices dropped sharply for a few years and then trended down at a more gradual pace for most of the next 15 years through the end of World War II.

The 1970s commodity supercycle was also preceded by a period of rapid economic growth starting in the 1960-a period fueled by expansionary fiscal policy, monetary accommodation, and speculative investment. The euphoric investment climate eventually spilled over to commodities, with energy and raw material prices surging during the 1970s and early 1980s.

Commodity supplies were also roiled during those years by the nationalization of most extractive industries in developing countries. Such actions discouraged foreign investment in the developing countries' commodity sectors and further increased global supply disruptions and price volatility. The flight of foreign investment from developing countries was a key reason for many countries' poor economic performance during the 1990s and was a major factor behind the tightening of commodity markets and shortages that lay the groundwork for the dramatic prices increases in the 2000s. - Farid Abolfathi

Sidebar 2: China's role in the current supercycle

While we can blame easy monetary conditions for facilitating the last decade's commodity supercycle, its key driver was the rapid economic expansion of emerging markets during most of the past two decades. In particular, it was China's dizzying pace of growth that underpinned the rapid rise of energy and raw material prices. Moreover, China's insatiable appetite for energy, raw materials, and other goods enabled other developing countries to sustain robust growth for the past two decades. In short, China's soaring demand for everything from iron ore to oil and gold was the dominant driver of the supercycle.

China's ascension to the World Trade Organization (WTO) in December 2001 was a watershed event, without which the supercycle might not have been possible. At a minimum, the cycle's amplitude and duration would probably have been far smaller. WTO membership not only boosted tremendously China's exports to the rest of the world, but also attracted huge volumes of foreign direct investment (FDI) into the country's manufacturing sectors. These, in turn, led to vast amounts of domestic capital being invested in precisely those industries that are intense users of energy and raw materials.

The domestic investment binge, which was easily financed by the Chinese people's excessive savings, generated an insatiable appetite for energy and raw materials during the last decade. Indeed, not only did levels of physical consumption of commodities rise, but the rate of their growth accelerated as well. It was this acceleration that started to strain commodity markets and pushed prices progressively higher-far above previous nominal cyclical peaks. Commodity prices roughly doubled between 2002 and 2004. They doubled again between 2004 and early 2008, before crashing during the Great Recession's global credit crunch.

China's 2008 crash proved remarkably brief, though. The Chinese authorities' implementation of an aggressive economic stimulus package in response to the Great Recession in late 2008 soon triggered a frenzied capital spending boom that in turn drove demand for many raw materials sky-high, pushing prices to unsustainable levels once again. For instance, the price of iron ore at China's Tianjin port climbed to about $200/ton by February 2011, nearly seven times higher than its average during the preceding decade.

Even though the vastly elevated price levels were not supported by market fundamentals, for many commodities the boom was sustained by what analysts sometimes refer to as "mania," or psychological factors. But eventually the day of reckoning did arrive. As China's economic growth decelerated over the last several years, broad-based commodity price indices ran out of steam. The IHS MPI, along with other commodity price indices, started to sag in 2011-slowly at first, but steadily.

The gradual downward trend continued for about two-and-a-half years, before culminating in last year's crash. Even though prices seem to have stabilized somewhat in recent months, they would likely decline further if China's economy continues to decelerate. - Farid Abolfathi